Greg Mankiw is worried that inflationary expectations are increasing and William Buiter argues that the Federal Reserve should reverse its easy monetary policy. But didn’t we just learn that the employment to population ratio fell from 62.9% to 62.7%. So how does Dr. Buiter reach the conclusion that the labor market is too strong?
The latest labour market figures show a large fall in employment and an even larger fall in labour supply, resulting in an actual decline in the unemployment rate to 4.8%. There is also evidence to support the view that the natural (equilibrium) rate of unemployment in the US is increasing. The combination of a declining actual unemployment rate and a rising natural unemployment rate means that there are now higher domestic inflationary pressures associated with any observed level of employment and unemployment than before. It will be argued that the labour supply data are unreliable, as they are based on the Household Survey. And so they are. But the employment data are unreliable also. And the decline in the recorded labour supply is not a one-month wonder. It has been in the data for quite a while, so I will believe it is real until I see convincing evidence of the contrary. It makes economic sense that the US natural rate of unemployment is increasing, if only because of compositional changes in the labour force that are reducing, on average, its quality and employability. The post-9/11 imposition of additional obstacles to the immigration of skilled labour are one factor reducing labour force flexibility. So is the long-standing decline in the numeracy and literacy standards of the high-school graduates. At the same time, the need for greater changes in the mix of skills and in the geographical and industrial distribution of employment associated with globalisation and accelerating technological change, have raised the degree of flexibility required to maintain the same amount of effective labour market pressure at a given level of the conventionally measured unemployment rate. The US is not responding, except defensively by threatening a retreat into protectionism.
Mark Thoma has an interesting discussion of how the natural rate of unemployment can vary over time but there are a couple of caveats here. Mark is not necessarily agreeing with Buiter’s contention. We should also note that there have been several economists (yes including me) that have advocated looking at this from a natural rate of the employment to population ratio – which admittedly can also vary over time.
Buiter seems to be under the impression that the all of the fall in the labor force participation rate is associated with a voluntary withdrawal of labor supply. I have to wonder. I have not update our graph of the labor force participation rate (LFP) and the employment to population ratio (EP), but it seems to be conveying the same message of why the unemployment rate (which is one minus the ratio of EP to LFP) is such a lousy measure of the state of the labor market. Ever since the 2001 recession and the slow and somewhat anemic recovery, LFP has declined from more than 67% to less than 66%.
Now if all of this decline in LFP were voluntary, then maybe Buiter’s argument makes sense. I once put forth the proposition that the natural rate of EP was 64% and was accused of assuming that none of the decline in LFP were voluntary. Maybe the truth is somewhere in the middle, which would then beg the question as to whether the natural rate of EP is some number like 63.5%, some number a bit above 63.5%, or perhaps even some number just under 63.5%. But I find it incredulous to believe that the natural rate of EP has fallen from 64% to something near 62.5%. Had Buiter presented clear evidence that the current EP exceeds its natural rate, I might agree for his call for tight money. But he really has not made the case – has he?
Update: A little comic relief. We know that Lawrence Kudlow has recently come down on the side of tight monetary policy as he fears inflation so it’s interesting that he agrees with John Ryding:
I am for economic stimulus. Don’t get me wrong. But I am for real economic stimulus which is cutting tax rates. Because this market is short of a few things: It’s short of liquidity—the Fed can deal with that. It’s short of capital. If we want more capital, we should start increasing the returns to capital, and cutting tax rates, or at least making tax cuts permanent. This is very important … You’ve got to get Washington to deliver on tax cuts and incentives.
Isn’t this the macroeconomic policy mix during 1981 that gave us a collapse of net exports from an overly strong dollar (something Kudlow endorses) and the 1982 recession? Of course, we could have a massive fiscal stimulus with little in the way of tight money, which might be inflationary if Buiter is even remotely correct about the labor market. Leave it to a clown like Kudlow to endorse such a disastrous policy mix!